Hanging to Your Gains in a Lofty Market

After a long bull market, most investors are sitting on healthy gains and a fair few are probably twiddling their thumbs wondering what to do next, if anything.

There is plenty of talks about an imminent crash. CAPE valuations are high, very high. VIX is low, very low. The only reasonable way to justify current asset valuations — be it stocks, bonds, or properties — is an expectation of persistently low interest rates for the foreseeable future, but we all know the global quantitative easing will be rolled back eventually, even if that eventually is likely years away. If you’re like me hoping to hang to your gains in this frothy market, there’s a tendency to start thinking about selling down or even getting out completely. (The emotional opposite of FOMO at play here.) But is that the right thing to do?

Kerr Nielson at the recent PMC AGM held in Sydney on 26 Oct 2017 provided a useful statistical way to think about this issue. For concreteness, suppose you’re able to spot an imminent crash and get out of the market, say, 6 months before the crash. From when you left to the market peak, you’ll leave about 14% of gains on the table. However, if you chose to stay in the market and ride through the crash, you’ll only be down about 10% from the market peak 6 months after the crash. In other words, suppose you have $1 million invested in the market 6 months out from the crash, withdrawing early will cost you about $26k + transaction costs in lost gain compared to the do-nothing strategy six months after the crash, on average.

To achieve better outcomes compared to doing nothing requires the ability to not only spot the incoming crash but time the crash as well. So if you can sell 3-6 months before the crash, then buy back into the market during the crash, you’ll do amazingly well. Alas while spotting a coming crash is quite possible — there are many people who can claim to have predicted 10 of the last 3 recessions 🙂 — knowing when the crash will happen is still beyond the capabilities of current Complexity Science. Absent the ability to time the crash, I would say doing nothing is a pretty useful strategy to deal with the last stages of a bull market. By all means, make minor adjustments with the portfolio if you must, sell down some richly valued assets and build up cash reserves, but don’t be foolish enough to get out of the market completely.